Liaoning’s economy is beset by a concentration of inefficient state firms—a fact highlighted in the first post in this provincial snapshot series, which focuses on this northeastern rustbelt province. Indeed, some of Liaoning’s state-owned enterprises (SOEs) are in such dire straits that a single state-led bailout has been insufficient. Not surprisingly, then, dealing with inefficient or failing SOEs has been a central preoccupation of provincial economic policy for decades. This second piece in my Liaoning series digs deeper into the SOE problem, looking at what’s happened to these Liaoning firms and then exploring some of the ways that they reflect national-level failures in dealing with endemic problems that plague China’s state sector.

The province’s poor record in dealing with SOEs sheds much light on China’s struggles to address debt in the state sector as a whole—now estimated at $15 trillion, or about half of China’s total debt. Market participants are increasingly anxious about debt in China’s state sector, not just because of its sheer size, but also because Beijing’s solutions and strategies have, up until this point, failed to effectively tackle the problem. One of Beijing’s most recent approaches—debt-to-equity swaps—has been on display at Liaoning’s Shenyang Machine Tool, a provincial SOE that has struggled so much to improve performance that it has needed two bailouts in 15 years.

Debt-to-equity swaps aren’t an entirely new solution, however. During the early 2000s, Beijing also carried out such swaps at hundreds of major SOEs around the country. The theory was that if such a solution were implemented well, it should not only better align the interests of the debtor and creditor but also improve the corporate governance of the debtor. But the previous round of swaps was successful only in keeping the firms alive and did not improve firm governance or raise efficiency, as was intended. Since then, it has become increasingly apparent that the state firms that benefitted from such arrangements did not ultimately embrace more sustainable business models.

Policy-Induced Complacency

During Liaoning’s decades-long process of restructuring its state sector, the raw number of SOEs declined by more than 70%, a result of the government’s tolerance for bankruptcies and privatization. But with so many money-losing SOEs being closed down, those that remained should have been stronger and more profitable. But peculiarly, those state firms left standing continued to flag in both profitability and efficiency (see Figure 1).

Figure 1. Fewer SOEs Have Not Led to More Profitable SOEs[1]
Source: National Bureau of Statistics (NBS).

So what happened in Liaoning that produced these policy failures that were theoretically based on good intentions? One of the key reasons was the macro environment that induced a sense of complacency across certain key state firms. It was a “soft policy environment” that shaped the behavior of large state firms. Such a complacent attitude was forged during the last round of SOE reforms, when Beijing’s guiding mantra was to “grasp the large, let go of the small.” That meant the smaller or less strategically significant SOEs would be abandoned while national champion firms would be preserved and supported.

In other words, firm size and its strategic status were both considered more important criteria than performance for determining which SOEs were to be saved. In that context, it is little wonder that the SOEs kept alive did not ultimately end up in better shape. After all, if poor performance is tolerated because of strategic “importance,” then raising efficiency was merely a peripheral priority. This sort of signaling and prioritization from the top seemed to have instilled an important lesson in inefficient SOEs: as long as they have “strategic” status, the central government will continue to provide generous transfers to them so they can and will survive.

The Unintended Consequences of Debt-to-Equity Swaps

Beyond the macro environment, additional factors specific to Liaoning explain why the province’s SOEs have continued to fare so badly. Perhaps the most significant of these is that debt-for-equity swaps have failed to produce long-term positive effects within the firms.

Starting around the year 2000, Beijing conferred numerous one-time favors on surviving SOEs, such as writing off their outstanding taxes. But the most consequential move that let these firms off the hook, so to speak, was to permit them to swap hundreds of billions of yuan worth of state bank lending into equities.

To be sure, this move was born of necessity: many of these SOEs were having difficulties making interest payments, much less repaying the principal that they owed. In the short term, therefore, there was simply no practical way for banks to recover SOE debts owed to them short of liquidating the firms, which Beijing would never have permitted.

Given these constraints—and since the government had already determined that these SOEs, however poor their performance, were strategically important enough to save—only two choices were left. The first option would be to have Beijing write off their nonperforming loans (NPLs); alternatively, the second option would permit SOE debt to be swapped into equities.

After choosing the latter option, the Chinese government moved to ensure that the newly created equities would be held by four asset management corporations (AMCs), each of them set up explicitly to deal with the state banks’ NPLs. In proportion to their ownership, these four AMCs received seats on the various SOEs’ boards of directors.

Compared to write-offs, debt-to-equity swaps had two benefits. First, Beijing could recover some of the losses by selling off the equities in the future. Second, and more important, Beijing hoped to use debt-to-equity swaps to transform SOEs into modern corporations.

Historically, China’s SOEs have been controlled by their managers, while the state’s supervision over those managers has been weak. The board, too, has been controlled by managers, so it also couldn’t meaningfully supervise managers. The lax external supervision gave SOE managers the freedom to pursue their own interests at the expense of SOE owners (i.e. the state). So debt-to-equity swaps were supposed to dilute SOE managers’ control, suggesting that Beijing, at a minimum, understood that the core problem of what ailed SOEs was corporate governance. These swaps, then, were used as a tool for improving governance.

But it didn’t work out that way, as the policy born out of necessity was insufficient in fundamentally altering the corporate structure of an SOE. Consider the example of Dongbei Special Steel, a large Liaoning SOE, which has recently caught international attention because of its high-profile default and the subsequent lengthy fight between the local government and the firm’s creditors.

After its debt-to-equity swap in 2003, three AMCs collectively assumed ownership of 35% of Dongbei Special Steel. By 2010, two of these three AMCs exited their investment. By 2015, less than one year before its bankruptcy, the board of Dongbei Special Steel was still dominated by insiders, who occupied 7 of the 12 board seats. And somewhat inexplicably, two of the directors appointed by Huarong, one of the two AMCs that has long since divested its holdings, still occupied board seats. The fact that no one actually seems to care who sits on the board of Dongbei Special Steel clearly suggests that the board itself is largely window-dressing and doesn’t have any real teeth.

Another problem that afflict SOE performance is Beijing’s pursuit of cutting-edge technology, with little consideration of cost. It is no secret that certain SOEs, central and local, are instruments in Beijing’s expansive industrial policy. To the extent that the central government places more of a premium on obtaining certain strategic and technological goals, operating efficiency of a firm becomes secondary. So if the SOE puts in place corporate boards oriented toward creating value and profit, the boards would likely not greenlight many of the moonshot projects that SOEs, in service to Beijing’s ambitious goals, have committed themselves to.

Shenyang Machine Tool, another flagship Liaoning SOE that’s allegedly China’s most advanced machine tool maker, further illustrates why this kind of top-down incentive distorts how a firm is expected to behave and perform. According to China Daily, Shenyang Machine Tool’s latest products rival that of industry leaders such as Siemens and Fanuc, and, the newspaper claims, this Chinese firm effectively “broke the monopoly” of foreign firms. This kind of publicity even got Shenyang Machine Tool a personal visit from President Xi Jinping in 2013, in which he praised the company’s research efforts and technological indigenization. The company has proudly displayed Xi’s remarks at the time that foreign companies won’t transfer leading technologies to China, even if “we beg for it.”

Such high-level political support helps explain why, despite having a very fragile balance sheet, Shenyang Machine Tool has not only managed to survive but expand. The state firm was first bailed out through a debt-to-equity swap in 2002. By early 2017, the firm was bailed out a second time using the same vehicle. Yet immediately after the 2017 swap, the SOE released its long-term plan, proposing to increase revenue to 30 billion yuan ($4.5 billion) by 2020 and eventually generating revenue of more than 100 billion yuan ($15 billion). The swap gave the struggling SOE some capital, but did not alter its corporate makeup. Within both Shenyang Machine Tool and its publicly listed subsidiary, six out of the nine board members remain insiders, meaning that control is still firmly in the hands of SOE managers. Unsurprisingly, no profit target has been announced.

These Liaoning SOEs’ behavior underscores how weak supervision of SOE managers and top-down incentives can lead to perverse outcomes. They allow local SOEs access to plenty of cheap funding, which would naturally make the choice easy for SOE managers to borrow as much as possible (see Figure 2). If debt-financed projects turn out well, then the managers can claim the credit and are rewarded for it. But when SOEs are unable to repay their loans, their strategically important status and the soft policy environment make state bailouts the norm and bankruptcies the exception.

Figure 2. Liaoning SOEs’ Debt BingeNote: Liaoning’s SOE statistics are likely more accurate than the province’s macroeconomic data, which have been found to be exaggerated or faked. In the recently released China Statistics Yearbook 2017, many of Liaoning’s headline economic indicators, such as GDP and industrial value-added, have been revised down by more than 20%. In contrast, previous SOE data are largely consistent with the latest release.
Source: NBS.

Will This Round of Debt-to-Equity Swaps be Different?

In this latest round of debt-to-equity swaps, Beijing has emphasized that it should be market driven. As such, the central government has pledged to let financial institutions freely negotiate with their borrowers without administrative intervention. Since the most recent round of debt-to-equity swaps started barely a year ago, there are few cases to analyze. Still, based on what’s currently available, it seems that the ongoing swap program has more similarities than differences with the previous round.

Consider the following: China’s State Council has made it clear that only SOEs that (1) have been losing money for three consecutive years and (2) don’t conform with government priorities will be restructured or liquidated. In reality, however, this means that the majority of SOEs will be safe, especially the large ones. That’s because although China’s securities regulator also delists publicly listed companies from the stock exchange after three consecutive years of losses, struggling state firms have routinely found ways to manipulate their financials to avoid delisting, such as by selling assets to turn losses into a profit.

The result is that unless an SOE is deeply in the red, state banks continue to keep them in business even if they’re technically insolvent. The handful of SOEs that have entered into bankruptcy have all been firms that lost too much money for too long. This is evidenced by the fact that their creditors have typically recovered no more than 20% of what they were owed. Were these bankrupt SOEs’ assets worth 50% of their debt, they would very likely have been saved rather than forced into bankruptcy.

For SOEs approaching insolvency, state banks are required not to withdraw their lending. Currently, close to 15 trillion yuan ($2.3 trillion) of lending has been lent to money-losing firms, mostly SOEs. Although it appears that banks have more freedom to deal with their borrowers than they did 15 years ago when they last had to deal with significant volumes of NPLs, they also have the responsibility to keep their borrowers in business even if this means pouring good money after bad.

During the last round of debt-to-equity swaps, the government chose which SOEs would be saved and decided the terms for the bailouts. It would appear, so far, the key difference this time is that financial institutions have more freedom in setting the bailout terms, but Beijing still decides which SOE will be saved.

If what has happened to Liaoning’s SOEs, such as Shenyang Machine Tool, is representative of broader trends (and I believe it is), then the prospects for changing this debilitating pattern do not look very good in the near term.

[1] NBS counts each SOE subsidiary separately. Many large SOEs have tens if not hundreds of subsidiaries. Each of the SOEs mentioned in the piece have multiple subsidiaries included in the total number of SOEs. For example, Dongbei Special Steel has 28 subsidiaries, and their total assets equal 3% of total Liaoning industrial SOE assets. Therefore, although not all Liaoning SOEs went through debt-to-equity swaps, those that did are large enough to be representative of the performance of an average Liaoning state firm.

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